In Brief

A value and momentum screen focused on finding under-valued, out-of-favor companies just at the point when the market is starting to recognise them. According to Lakonishok, investors have judgmental biases and behavioral weaknesses including the tendency to extrapolate the past too far into the future, to wrongly equate a good company with a good investment irrespective of price, to ignore statistical evidence and to develop a quot;mindsetquot; about a company. As a result, quot;value stocks become underpriced and glamour stocks become overpriced relative to their fundamentals quot;. He believes these biases and weaknesses can be exploited to achieve superior long term returns.

Background

In a 1994 study Contrarian Investment, Extrapolation and Risk, Lakonishok, Andrei Shleifer, and Robert Vishny examined the performance of value stocks relative to that of "glamour" securities in the United States over a 26-year period. The authors found that value stocks tended to outperform glamour stocks by wide margins. In his view, this is mainly because of investors extrapolating past fundamental performance too far into the future, resulting in many well performing stocks becoming overpriced and many poorly performing stocks becoming underpriced.

Along with fellow academics Andrei Shleifer (Harvard University) and Robert Vishny (now both retired), Josef Lakonishok set up Chicago-based LSV Asset Management, which now manages over $65 billion in assets for both institutional and individual accounts using quantitative models to find value-oriented companies.

Lakonishok looks for potentially undervalued companies by comparing four key ratios. As well as traditional price-to-book value measure, he looks at price to-cash flow, price-earnings, and price-to-sales ratios. If the company's stock price is below the industry average based on any one of these four ratios, it's worth a closer look. However, identifying a group of out-of-favor stocks is just the beginning. The trick is to ascertain which of them are likely to rebound vs. being cheap for a reason, such as being near bankruptcy. He looks for value stocks that are beginning to show some sign of momentum, either in terms of price momentum (relative strength) or in terms of improving analyst sentiment and earnings surprise.

Screen Criteria

Without knowing the details of LSV's investment criteria, an indicative set of Lakonishok-inspired screening metrics might be:

At least one of Price-to-book, price-to-cash-flow, price-earnings or price-to-sales ratios more favourable than the industry

6 Month relative strength above zero

3 month relative strength above zero

Earnings surprise - In Momentum Investing, Lakonishok examines three inter-related measures which he finds to be synergistic:

Standard earnings surprise at the time of the most recent interims (vs. forecasts)

Abnormal returns around recent earnings announcements

Revision in the analyst consensus - either now or trending over the last 6 months

Of course, the special ingredient in his approach is said to come from how much weight is attached to each value/momentum measure and to diversification. With few exceptions, no one stock makes up more than 1.6% of the portfolio,and no single industry makes up more than 3% relative to the weight in the corresponding benchmark. Stocks that have been public for less than two years also are apparently ruled out.

Does it Work

The Lakonishok screen on AIII has made a 15.7% CAGR since inception, compared with 2.3% for the Samp;P 500. There's an interesting discussion on the alpha generated by LSV's flagship mutual fund, Value Equity Fund (LSVEX) on Insider Monkey.

Watch Out For

Josef Lakonishok warns against ignoring statistical evidence and to develop a 'mindset' about a company. He notes: "we don't visit companies, and we don't talk to analysts". He also cautions investors against quot;the tendency to extrapolate the past too far into the futurequot; and quot;to wrongly equate a good company with a good investment irrespective of price.